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rbi: Monetary expansion during downturn is not inflationary: RBI Research Paper

By on June 18, 2022 0
Mumbai: It is said that too much money for too few goods is inflationary. But that may only be partially true. Empirical findings from a study by economists at the Reserve Bank of India (RBI) suggest that monetary growth does not pose risks to inflation in the presence of economic downturn.

When the economy is in an expansionary phase, however, an increase in the money supply can lead to higher inflation, implying that monetary accommodation during Covid-19 by the central bank must be reversed once the economy returns to its normal path of growth.

Well-known economist and Nobel laureate

Friedman’s theory that guided monetary policy around the world in the second half of the 20th century stated that inflation is a monetary phenomenon and occurs when too much money chases too few goods. Excess money creation, or the unbridled expansion of the size of a central bank’s balance sheet, has therefore been cited as the main driver of inflation.



But this has been changing since the turn of the 20th century across the world and the link between money supply and inflation is weakening – even in India. The empirical results suggest that monetary growth does not pose risks for inflation during an economic downturn. However, when the economy is in an expansion phase, an increase in the money supply can lead to higher inflation, according to a research paper published in the latest RBI Bulletin.

The authors are Sitikantha Pattanaik, Binod B. Bhoi and Harendra Kumar Behera from the Department of Economics and Policy Research. The research findings are those of the authors of the Economic Research Department of the RBI and do not reflect the views of the RBI itself.

“The empirical results for India suggest that excess liquidity that does not lead to higher broad money growth is not inflationary,” the authors said. “Only a strong recovery in demand capable of absorbing the excess liquidity in the system could be inflationary.”

The research is gaining momentum as central banks around the world that were in quantitative easing mode after the 2008 global financial crisis and continued to aggressively expand their balance sheets are now turning to quantitative tightening. Back in India, the RBI is being criticized for falling behind in its fight against inflation.

The authors argue that higher money growth may offset the contractionary impact of the velocity shock rather than pose risks to inflation. Furthermore, Friedman’s theory is less and less likely to hold in the era of financial innovations, the rise of non-monetary digital payment methods for transactions and also given the emergence of FinTech for the financial intermediation.